The government is struggling to contain the bad loan crisis, which appears to be growing unabated. Bad loans, called NPAs, threaten the viability of banks and pose risks to India’s financial stability. Despite a high economic growth, the risk of bank failures and a systemic contagion is real and increasing in probability. Additionally, NPAs are preventing banks from offering new credit to businesses in need, thereby affecting future economic growth.

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The government and the Reserve Bank of India (RBI) need to act fast to stabilise and strengthen the financial system. It would be a mistake to depend on the slow process of allowing banks to sell distressed assets or recovering bad loans. The government’s two recent proposals, to recapitalise state-run banks and to merge other banks with the State Bank of India, are terrible ideas and a gross misuse of both public funds and financial logic.

There are two kinds of bad loans on the books of Indian banks. First, there are the out-and-out frauds — estimated at 20 per cent of the total bad loans. There is little hope of recovering much from these fraudulent loans. The second kind, which is bad debt belonging to distressed companies, could potentially be recovered, but only if the government is willing to use market-based solutions. Restructuring distressed companies is a specialised business handled by a rare group of professionals who have the courage for risk purchasing nonviable companies and the business acumen to turn them around and sell them for a profit. This is not something that anyone in government or bureaucracy is skilled in handling.

India’s fast-growing NPA problem can only be solved through the capital markets. In the US, almost a trillion dollars of bad debt is handled every year through an active secondary market which consists of a) Asset Restructuring Companies (ARCs) that specialise in buying bad loans from banks and repackaging them into smaller units — a process called securitising and b) institutional investors, such as private equity funds, asset managers, insurance companies, and pension funds who buy this distressed debt from the ARCs. A robust and transparent secondary market, unencumbered by excessive regulation, is an essential element in the vital process of transferring risk from the banks to the capital markets.

The creation of a secondary market for distressed assets in India will allow for a faster and more efficient resolution of distressed loans and provide a framework for addressing future NPA problems. Over time, such a market could become a regular instrument for banks to use in managing NPAs and improving overall risk management. An active secondary market for bad assets will also allow proper pricing of bad loans and more truly reflect the rehabilitated value of businesses. But, most importantly, a viable secondary market for distressed debt will allow for the creation of financial instruments such as forward contracts, credit default swaps and credit derivatives which are vital tools that enable banks to transfer credit risk to other parties while keeping the loan on their books.

India’s NPA problem is not unique. After its financial crisis in the late 1990s, Korea created credit recovery vehicles (CRVs), which are essentially ‘bad banks’, i.e. a bank that is structured only to hold the bad loans of other banks.

These CRVs, in partnership with private investors, took over distressed assets from the banks and restructured them using ARCs. The Korean government supported the growth of these ARCs with special regulatory treatment and tax benefits. Japan, too, faced severe NPA problems in 1991 and used a slew of market-based solutions including securitisation of NPAs, and ARCs to rehabilitate troubled firms. The Swedish economy, hit by a banking crisis from 1991-94, transferred the assets of the ailing banks to ARCs, which restructured the distressed companies by replacing management, cutting costs, merging and selling assets and converting debt into equity to restore profitability. And in 2008, Iceland, faced with a banking crisis of extraordinary proportions with corporate NPA ratios of 50 per cent, fostered a successful debt restructuring process led by the private sector and a secondary market for distressed debt.

Foreign investors are eager to participate in India’s Distressed Debt sector especially since the passing of the Insolvency and Bankruptcy Code, 2016, which expedites the insolvency process to less than one year. But they are very sceptical about anything connected to the government and the public sector because of the usual issues related to poor implementation, burdensome and inconsistent regulation, and lack of transparency. If the NPA problem is to be resolved quickly and successfully, this outside capital must be tapped using market-based solutions. The government must limit its involvement and back off from the regulatory pedal, and help create an environment that encourages Asset Recovery Companies and outside investors to take on the sizeable risks associated with rehabilitating India’s distressed companies.

The global financial sector is undergoing structural changes, and alternative suppliers of financial services (fin-tech and other non-banking entities) are challenging existing business models. Cost reduction and innovation are the keys to survival in this environment, and it is clear that personnel-heavy, and non-innovative public sector banks are ill-equipped to compete in this rapidly-changing, high-technology, low-cost environment. It is imperative that India’s state-owned banks be allowed to exit in a controlled way so their market share can be freed up for other viable banks. This process of privatising government banks should begin along with the creation of a viable secondary market for distressed debt.

The author is the founder, contractwithindia.com.Views expressed are personal.